Why Do Consumers Buy Extended Service Warranties That Offer Little or No Value?

PITTSBURGH—For years, consumer advocates have warned that extended service contracts (ESCs) are not a good deal, but shoppers continue to snap them up anyway. This curious contradiction has gone unexplained until now. First-of-its-kind research from the Tepper School of Business at Carnegie Mellon University identifies several key reasons for the enduring appeal of ESCs, chief among them product nature, retailer actions and consumer characteristics.

The Tepper study, the first to examine purchases of extended service contracts in a retail environment using field data rather than in controlled settings, found that consumers are more prone to buy ESCs for "pleasure purchases" (e.g., Blu-Ray players or iPods) rather than utilitarian items like desktop computers and printers. "Buyers often place more value on pleasure purchases, feel there is a greater risk to their well being if they do not function, and are willing to pay extra to protect them," said Baohong Sun, the Carnegie Bosch Professor of Marketing and co-author of the study.

Moreover, retailers often attract buyers to ESCs by offering promotions, particularly unadvertised in-store discounts, on pleasure products. The discounts give buyers the feeling that they are ahead of the game in terms of purchase price, which disposes them toward spending the perceived savings on extended warranties. According to the study, women and men purchase ESCs at near equal rates, despite the fact that women are more risk-averse than men. The research also found low-income consumers buy more ESCs because they are more sensitive about replacement costs in the event of product failure. Higher-income consumers aren't as concerned about costs related to product failure, and thus are less likely to purchase ESCs even when the product is discounted.
The Problem with ESCs

ESCs were first introduced by large electronics stores in the late 1980s and have since become a core product for many retail outlets, covering a range of categories and accounting for a greater share of profits. For example, ESC sales generated approximately $15 billion in both 2004 and 2005.i By 2007, consumers were spending $8.3 billion on warranties for computers, computer electronics and major appliances alone.ii The ESC market has continued to grow, with the percentage of shoppers adding a warranty to a purchase increasing to 10 percent in 2009.iii

While ESCs have been a boon for retailers, they do not offer much benefit for consumers and can actually be detrimental. Their cost, usually between 10 and 50 percent of an item's original price,iv frequently raises the total cost of products beyond what buyers are likely to spend — even when the products are discounted. "And this added expense is usually of limited or no value, because it protects consumers from repair costs on products that for the most part, are unlikely to fail during the term of the warranty — usually one to three years depending on the product category," noted Sun. Like ESC costs, failure rates differ dramatically from product to product. For example, the rates for television equipment, games and phone equipments are 9 percent, 18 percent and 26 percent respectively.v

"When you consider that low-income buyers are more likely to purchase ESCs, it is evident they can have a perverse impact on consumer welfare," adds Sun. "They increase the price of goods for those who can afford it least."

Professor Sun developed the study with colleagues Tao Chen and Ajay Kalra at the Tepper School. The team analyzed 1,676 products and 553 ESC purchases from 604 households. The data represents a full year's worth of tracking from a retailer's electronics department. The resulting paper, "Why Do Consumers Buy Extended Service Contracts?," appears in the December 2009 issue of Journal of Consumer Research.